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Uncle Samâs Gift to Parents
Tip of the Month
April 2003
Uncle Samâs Gift to Parents
Having children makes you eligible for several tax savings. Dependent exemption is the first, second you may be eligible for a couple credits and third you can save for the childâs college education. You can also lower your taxes by shifting some of your high income to your child, either as a gift or as salary if you are a business owner.
Filing status
The first tax-return item is the choice of how to file. The married-filing-jointly option offers a larger standard deduction and allows some tax breaks that are denied unmarried filers. If, however, you are raising children alone, don't shortchange yourself by choosing the wrong status. You can file as a head of household if, for more than six months, you provided over half the cost of keeping up a home for yourself and your kids. Tax rates and the standard deduction for head-of-household filers are more favorable than those for the single or married-filing-separately categories.
Parents who have lost spouses also have a choice. You may file as a qualifying widow or widower with a dependent child for two years after the year your husband or wife died. This status gives you the same filing consideration afforded married filers. For example, a father whose wife died in 2001 could use this category for 2002 and 2003 returns. (He would have filed as married filing jointly on his 2001 return, the year he lost his wife.) For the subsequent tax years as a qualifying widower, he can use the joint tax rates and, if he doesn't itemize, claim the highest standard deduction amount. Exemptions, AKA dependents
A prime child-related tax saving comes from the additional personal exemption you claim on your return. The IRS sets a dollar amount (adjusted annually for inflation) that you multiply by the number of your exemptions. That amount is then subtracted from your income. The lower your income, the lower your tax bill.
Each dependent is an exemption. The IRS has rules on just who qualifies as a taxpayer's dependent. That's generally not a problem for parents with young kids at home. But what about when they earn their own money from an after-school job or are off at college? While you may have to do a little figuring, especially to see if your young worker needs to file his own return, this generally won't invalidate the kid's status as your dependent. The key considerations here are whether you are the child's primary source of support or if he's a full-time student at State U.
If you're filing as a single parent for the first time, other child-related issues arise. Where a formal divorce decree is involved, be sure you follow the custody rules set out there. They determine who gets to claim the children. When custody is shared, parents must decide who claims the children. Often, the dependent deduction is split, with the father claiming one child and the mother the second one. Make sure you and your ex are clear on this so that double dependent claims don't raise any Internal Revenue Service red flags.
Tax credits
Your growing family also could make you eligible for several tax credits. The great thing about tax credits is that they reduce your tax liability on a dollar-for-dollar basis. A credit of $500 could cut your $1,000 tax bill in half. If you owe no tax, some credits even will get you a refund.
Most parents qualify for at least one of three popular credits: the child tax credit, the additional-child tax credit and the child- and dependent-care credit.
The child tax credit and its companion additional-child tax credit can cut your tax bill by several hundred dollars for each youngster you claim. For the child tax credit, there are no records to keep or extra forms to file to get a $600 credit for each child.
The credit's basic requirement is that your child be younger than 17 and claimed as a dependent on your return. You will have to fill out a worksheet to figure your exact credit amount, especially if you make a lot of money since the credit is reduced for high earners.
If you claim tax relief for more than one kid, you must fill out Form 8812 to compute your additional child tax credit. But the paperwork could well be worth it. This tax break allows filers who owe little or no taxes to get a refund check from the IRS.
Working parents who put the kids in day care can file for the child and dependent care credit to recoup some of those costs. This tax break applies to care for children younger than 13, but the precise credit is based on a limited amount of your actual child care expenses. You can use only up to $2,400 you spent to care for one child, $4,800 for two or more.
Another popular tax break helps parents whose bundle of joy arrived via an adoption. Adoptive parents can get up to a $10,000 credit on their taxes to cover expenses. But like parenting, claiming the credit is not easy. The exact year you can claim your expenses depends on several factors, including when they were paid, when the adoption was finalized and even whether your new son or daughter is a U.S. citizen or resident.
Education expenses
College costs are skyrocketing, prompting many parents to start saving as soon as the little one arrives. Uncle Sam offers several tax-favored ways to help.
With a Coverdell Education Savings Account, a redesigned version of the old education IRA, parents (or grandparents or even just friends) can put away up to $2,000 a year (total, not apiece) for a youngster's schooling. While adults contribute to the savings plan, a child age 17 or younger is named as the account's beneficiary. The contributions aren't tax deductible, but they and their earnings can be withdrawn tax-free as long as they are used to pay eligible schooling costs. And while many of these accounts are opened expressly to pay university costs, Coverdell cash can be used for some pre-college expenses, including tuition, room and board, and books and computers for public, private or parochial primary schools.
Once Johnny or Julie are on campus, Uncle Sam offers a couple of education tax credits to help pay the costs.
The Hope Scholarship credit can be used for expenses incurred during the first two years of post-secondary education. It can be worth up to $1,500 per student, per year. Graduate and professional-level programs are not eligible.
For additional school years, look to the Lifetime Learning credit, which could cut $1,000 off your tax bill. The credit can be used for undergraduate, graduate and professional degree courses for anyone (including yourself if you want to show your kids that the old parental unit can learn a few things too!).
Credits usually are more tax beneficial than deductions, but that doesn't mean you should automatically discount a new tax break on 2002 returns. The tuition-and-fees deduction appears on both Form 1040A and Form 1040 and lets you subtract up to $3,000 of eligible schooling costs from your income. The deduction's immediate attraction is that it doesn't require you to fill out Schedule A or meet any percentage-of-income minimum. Plus, you can count undergraduate and graduate expenses for your kids even if they aren't full-time students.
Income shifting
You also may be able to lower your tax bill a bit by shifting some of your higher-taxed income to your kids in lower tax brackets. By transferring your income that is taxed at 35 percent to your youngster in the 15 percent bracket, you'll save 20 cents on every dollar of income. Such tax-reduction strategies are legal as long as they follow IRS rules.
A common technique is moving investment properties. Keep in mind that you can't simply transfer the investment income. The asset that produces the earnings must legally belong to the youngster. And this maneuver works best if your child is at least 14. At that age, the youth's income is taxed at their usually lower rate.
But if your child is 13 or younger, you'll have to deal with the kiddie tax, a provision created in 1986 to keep parents from illegally sheltering income. For younger kids, the first $750 in investment income is tax free, the next $750 is taxed at the child's rate and any earnings above that are taxed at the parent's rate. Your child's earnings are, in essence, added to your taxable income amount. This extra money could push you into a higher tax bracket and could mean the loss (or at least reduced benefit) of some tax deductions and credits that are phased out as income grows.
Still, if you have a property that's not going to push the $1,500 limit or your child is nearing 14, look into whether a move here could help cut your taxes.
If you own your own proprietorship, reduce your taxable self-employment income by hiring your kids. Your company gets a deduction and your child pays income taxes at there lower rate.
Just remember, the job and wages must be reasonable. If you pay an excessive salary to your 16-year-old for a job he's not equipped to perform, an IRS examiner is likely to take a closer look. That scrutiny could quickly erase any tax savings you thought you had gained.
Filing status
The first tax-return item is the choice of how to file. The married-filing-jointly option offers a larger standard deduction and allows some tax breaks that are denied unmarried filers. If, however, you are raising children alone, don't shortchange yourself by choosing the wrong status. You can file as a head of household if, for more than six months, you provided over half the cost of keeping up a home for yourself and your kids. Tax rates and the standard deduction for head-of-household filers are more favorable than those for the single or married-filing-separately categories.
Parents who have lost spouses also have a choice. You may file as a qualifying widow or widower with a dependent child for two years after the year your husband or wife died. This status gives you the same filing consideration afforded married filers. For example, a father whose wife died in 2001 could use this category for 2002 and 2003 returns. (He would have filed as married filing jointly on his 2001 return, the year he lost his wife.) For the subsequent tax years as a qualifying widower, he can use the joint tax rates and, if he doesn't itemize, claim the highest standard deduction amount. Exemptions, AKA dependents
A prime child-related tax saving comes from the additional personal exemption you claim on your return. The IRS sets a dollar amount (adjusted annually for inflation) that you multiply by the number of your exemptions. That amount is then subtracted from your income. The lower your income, the lower your tax bill.
Each dependent is an exemption. The IRS has rules on just who qualifies as a taxpayer's dependent. That's generally not a problem for parents with young kids at home. But what about when they earn their own money from an after-school job or are off at college? While you may have to do a little figuring, especially to see if your young worker needs to file his own return, this generally won't invalidate the kid's status as your dependent. The key considerations here are whether you are the child's primary source of support or if he's a full-time student at State U.
If you're filing as a single parent for the first time, other child-related issues arise. Where a formal divorce decree is involved, be sure you follow the custody rules set out there. They determine who gets to claim the children. When custody is shared, parents must decide who claims the children. Often, the dependent deduction is split, with the father claiming one child and the mother the second one. Make sure you and your ex are clear on this so that double dependent claims don't raise any Internal Revenue Service red flags.
Tax credits
Your growing family also could make you eligible for several tax credits. The great thing about tax credits is that they reduce your tax liability on a dollar-for-dollar basis. A credit of $500 could cut your $1,000 tax bill in half. If you owe no tax, some credits even will get you a refund.
Most parents qualify for at least one of three popular credits: the child tax credit, the additional-child tax credit and the child- and dependent-care credit.
The child tax credit and its companion additional-child tax credit can cut your tax bill by several hundred dollars for each youngster you claim. For the child tax credit, there are no records to keep or extra forms to file to get a $600 credit for each child.
The credit's basic requirement is that your child be younger than 17 and claimed as a dependent on your return. You will have to fill out a worksheet to figure your exact credit amount, especially if you make a lot of money since the credit is reduced for high earners.
If you claim tax relief for more than one kid, you must fill out Form 8812 to compute your additional child tax credit. But the paperwork could well be worth it. This tax break allows filers who owe little or no taxes to get a refund check from the IRS.
Working parents who put the kids in day care can file for the child and dependent care credit to recoup some of those costs. This tax break applies to care for children younger than 13, but the precise credit is based on a limited amount of your actual child care expenses. You can use only up to $2,400 you spent to care for one child, $4,800 for two or more.
Another popular tax break helps parents whose bundle of joy arrived via an adoption. Adoptive parents can get up to a $10,000 credit on their taxes to cover expenses. But like parenting, claiming the credit is not easy. The exact year you can claim your expenses depends on several factors, including when they were paid, when the adoption was finalized and even whether your new son or daughter is a U.S. citizen or resident.
Education expenses
College costs are skyrocketing, prompting many parents to start saving as soon as the little one arrives. Uncle Sam offers several tax-favored ways to help.
With a Coverdell Education Savings Account, a redesigned version of the old education IRA, parents (or grandparents or even just friends) can put away up to $2,000 a year (total, not apiece) for a youngster's schooling. While adults contribute to the savings plan, a child age 17 or younger is named as the account's beneficiary. The contributions aren't tax deductible, but they and their earnings can be withdrawn tax-free as long as they are used to pay eligible schooling costs. And while many of these accounts are opened expressly to pay university costs, Coverdell cash can be used for some pre-college expenses, including tuition, room and board, and books and computers for public, private or parochial primary schools.
Once Johnny or Julie are on campus, Uncle Sam offers a couple of education tax credits to help pay the costs.
The Hope Scholarship credit can be used for expenses incurred during the first two years of post-secondary education. It can be worth up to $1,500 per student, per year. Graduate and professional-level programs are not eligible.
For additional school years, look to the Lifetime Learning credit, which could cut $1,000 off your tax bill. The credit can be used for undergraduate, graduate and professional degree courses for anyone (including yourself if you want to show your kids that the old parental unit can learn a few things too!).
Credits usually are more tax beneficial than deductions, but that doesn't mean you should automatically discount a new tax break on 2002 returns. The tuition-and-fees deduction appears on both Form 1040A and Form 1040 and lets you subtract up to $3,000 of eligible schooling costs from your income. The deduction's immediate attraction is that it doesn't require you to fill out Schedule A or meet any percentage-of-income minimum. Plus, you can count undergraduate and graduate expenses for your kids even if they aren't full-time students.
Income shifting
You also may be able to lower your tax bill a bit by shifting some of your higher-taxed income to your kids in lower tax brackets. By transferring your income that is taxed at 35 percent to your youngster in the 15 percent bracket, you'll save 20 cents on every dollar of income. Such tax-reduction strategies are legal as long as they follow IRS rules.
A common technique is moving investment properties. Keep in mind that you can't simply transfer the investment income. The asset that produces the earnings must legally belong to the youngster. And this maneuver works best if your child is at least 14. At that age, the youth's income is taxed at their usually lower rate.
But if your child is 13 or younger, you'll have to deal with the kiddie tax, a provision created in 1986 to keep parents from illegally sheltering income. For younger kids, the first $750 in investment income is tax free, the next $750 is taxed at the child's rate and any earnings above that are taxed at the parent's rate. Your child's earnings are, in essence, added to your taxable income amount. This extra money could push you into a higher tax bracket and could mean the loss (or at least reduced benefit) of some tax deductions and credits that are phased out as income grows.
Still, if you have a property that's not going to push the $1,500 limit or your child is nearing 14, look into whether a move here could help cut your taxes.
If you own your own proprietorship, reduce your taxable self-employment income by hiring your kids. Your company gets a deduction and your child pays income taxes at there lower rate.
Just remember, the job and wages must be reasonable. If you pay an excessive salary to your 16-year-old for a job he's not equipped to perform, an IRS examiner is likely to take a closer look. That scrutiny could quickly erase any tax savings you thought you had gained.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.
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